Price methods and Price
Discrimination
Pricing Methods
Price Discrimination
Prepared By:
Zegeye Demissie
Nabil Abdurrahman
June 20, 2012
Out Line
Market Structure and Pricing
Perfect competition
Monopolistic competition
Oligopoly
The oligopoly Models
Sweezy Kinked demand curve model,
Price leadership Models
Collusive model, the cartel arrangement
Game theory
-Monopoly
Price discrimination
- 6.1.1 Necessary condition for Price Discrimination
-Price Discrimination by Degrees (1st , 2nd, 3rd degree)
Summary
Market Structure and Pricing
 A market can be defined as a group of economic agents, usually
firms and individuals, who interact with each other in a buyer–
seller relationship. This is fine as a general definition but it lacks
practical applicability in defining a specific market.
 Economists usually classify market structures into four main
types: perfect competition, monopoly, monopolistic competition
and oligopoly.
 The following Table show the Behavior of markets
Market
No.of
Type
Barrier Power
Market
Structure
andofPricing
structure
sellers
product
Non-price
of
to entry to price competition
affect
Perfect
Many
Standardized
None
None
Many
Differentiated
Low
Low
None
Competition
Monopolistic
Competition
Advertising and
product
Differentiation
Oligopoly
Few
Standardized
or product
Differentiated
High
Medium Heavy
advertising
and
Differentiated
Monopoly
One
Single
Very
product
high
High
High Advertising
Perfect competition
 There are five main conditions for perfect competition to exist:
 1 Many
buyers and sellers. Each of these must buy or sell such
a small proportion of the total market output that none is able
to have any influence over the market price.
 2 Homogeneous product. Each firm must be producing an
identical product, for example premium unleaded petrol or
skimmed milk.
 3 Free entry and exit from the market. This means that there
are no barriers to entry or exit that give incumbent firms an
advantage over potential competitors who are considering
entering the industry. These barriers, which can represent
either demand or cost advantages, are explained in more detail
in the next section.
Perfect competition….
 4 Perfect knowledge. Both firms and consumers must
possess all relevant market information regarding
production and prices.
 5 Zero transportation costs. This means that it does not
cost anything for firms to bring products to the market
or for consumers to go to the market.
Monopolistic competition
 There are five main conditions for monopolistic competition to





exist:
There are many buyers and sellers in the industry.
2. Each firm produces a slightly differentiated product.
3. There are minimal barriers to entry or exit.
4. All firms have identical cost and demand functions.
5. Firms do not take into account competitors’ behavior in
determining price and output.
Oligopoly Market
 The main conditions for oligopoly to exist are
therefore as follows:
 A relatively small number of firms account for the
majority of the market.
 There are significant barriers to entry and exit.
 There is interdependence in decision-making.
Unregulated, comparable products are markedly
cheaper.
Sweezy Kinked demand curve model,
 This model was originally developed by Sweezy and has been
commonly used to explain price rigidities in oligopolistic markets.
Price rigidity refers to a situation where firms tend to maintain
their prices at the same level in spite Market structure and pricing
of changes in demand or cost conditions.
 The model assumes that if an oligopolistic cuts its prices,
competitors will quickly react to this by cutting their own prices
in order to prevent losing market share. On the other hand, if one
firm raises its price, it is assumed that competitors do not match
the price rise, in order to gain market share at the expense of the
first firm. In this case the demand curve facing a firm would be
much more elastic for price increases than for price reductions.
This results in the kinked demand curve.
Price leadership Models:
 A commonly observed pattern of behavior in oligopolistic
industries is the situation where one firm sets a price or
initiates price changes, and other firms follow the leader
with a short time lag, usually just a few days. There are
various ways in which such behavior can occur, depending
on two main factors.
 1. Product differentiation. For homogeneous
products the followers normally adjust their prices to the
same level as the leader. In the more common case of
differentiated products the price followers generally
conform to some structure of recognized price differentials
in relation to the leader. E.g. Ford may adjust the prices of
various models so that they are given percentages lower or
higher than some benchmark GM model.
:
Price leadership Models
 Type of leadership. There are two main possibilities here.
Dominant price leadership refers to the situation where the
price leader is usually the largest firm in the industry. In this case
the leader is fairly certain of how other firms will react to its
price changes, in terms of their conforming to some general
price structure,
 The other main type of price leadership is called barometric.
This time the price leader is not necessarily the largest firm, and
leaders may frequently change. There is more uncertainty in this
case regarding competitive reactions, but the leader is normally
reacting to changes in market demand ,cost conditions.
Collusive model, the cartel arrangement
 Collusion is the term frequently used to refer to co-
operative behavior between firms in an oligopolistic
market. This is an agreement among firms, of a formal
or informal nature, to determine prices, total industry
output, market shares or the distribution of profits.
 E.G On an international basis the best-known cartel is
OPEC, the Organization of Petroleum Exporting
Countries,
Factors affecting success of a cartel
Number of sellers
Firms are more likely to have disagreements regarding
price and output strategies
 Product differentiation
There are different grades according to country of origin,
and sellers can also vary payment terms as a form of
competition.
 Cost structures.
As with differences in product, differences in cost
structures can make co-operation more difficult.
 Transparency

11.6 Oligopoly Behavior: Game Theory
Overview
 Game Theory is a study of how people behave in
strategic situations. This applies to oligopolies because
there are only a few major firms. Their profit will
depend on the strategy each firm chooses and the
strategy its rival chooses.
 See the next Figure (4 possible strategies & 2 firms are
involved)
Oligopoly Behavior: Game Theory
Overview
 Oligopolies are encouraged to collude or cooperate with
their rivals
 Revisit the Game Theory model of decision-making
 Oligopolies are also encouraged to “cheat”
Monopoly
 After an analysis of perfect competition it is usual to consider monopoly
next. Again, this is not because this is a frequently found type of market
structure, but because as an extreme form it provides a benchmark for
comparison. As we shall see, it can also be claimed that many firms are in
effect limited monopolies.
 Economists have defined monopoly in many different ways. Literally, it
means a single seller in an industry. However, it is preferable to define a
monopoly as being a firm that has the power to earn supernormal profit
in the long run. This ability depends on two conditions:
 1 There must be a lack of substitutes for the product. This means that any
existing products are not very close in terms of their perceived functions
and characteristics. Electricity is a good example.
 2 There must be barriers to entry or exit. These are important in the
long run in order to prevent firms entering the industry and competing
away the supernormal profit. We now need to examine them in detail.
Monopoly
 There must be a lack of substitutes for the product. This means that
any existing products are not very close in terms of their perceived
functions and characteristics. Electricity is a good example.
 2 There must be barriers to entry or exit. These are important in
the long run in order to prevent firms entering the industry and
competing away the supernormal profit. We now need to examine
them in detail.
PRICE DISCRIMINATION
By Nabil Abdurrahman
Price Discrimination
Selling the same good to different people at
different prices
A tool that firms use to extract additional surplus
from consumers
Example
Price Discrimination
Conditions necessary:
 Imperfect competition in the market.(Monopoly)
 Identifiable customer groups with differing price
elasticities
 Maintain separation of groups--prevent resale.
1st Degree Price Discrimination
where firms would like to charge the
maximum amount that the consumer
would be willing to pay
 For firms this is basically the best
situation they can reach, gives them the
best opportunity to extract surplus
from the consumer.
1st Degree Price Discrimination
 It requires that the firms know exactly
how much each consumer is willing to
pay
 extremely difficult to implement
because the firm must have perfect
information which is very difficult to
have
1st Degree Price Discrimination
 Even though it is difficult to implement
there are still businesses that can
implement this style.
1st Degree Price Discrimination
Identify and charge each customer
what they are willing to pay. Limit:
D = MR, no consumer surplus.
Same Market
Different People
Different Price
2nd Degree Price Discrimination
Quantity discounts. Volume purchases
are given lower prices. Need to
measure goods and services bought by
consumers.
setting a discrete schedule of declining
prices for a different range of quantities
2nd Degree Price Discrimination
 allows the firm to charge higher prices
to different groups of individuals even
though it doesn’t know the maximum
amount that each consumer is willing to
pay
 the firms let consumers sort themselves
into the groups and price that they are
willing to pay
2nd Degree Price Discrimination
 Different Customers
 Different Price
 Same Market
Example
EEPCO
 where it charges higher rates for the
first set amount of electric usage and
then lower the price depending on the
schedule.
 Ethio telecom
 where it charges lower rates for Happy
Hours(09PM-07AM)
2nd Degree Price Discrimination
2nd Degree Price Discrimination
 The graph shows where the firm sells it product at
one price P1 and at quantity Qa that is point X. With a
second degree price discrimination they will also
charge a second price on a discrete schedule they had
set up. To gain more profits they will charge a price P2
and Qa at Point Y. So they can sell more quantity of
their product at a cost that the consumer’s who were
not willing to pay at the higher price are now willing
to pay at the lower price
3rd Degree Price Discrimination
Is when firms recognize that the
demand for their product is different for
each group of consumers.
This pricing strategy can only exist
when firms have some price setting
power
3rd Degree Price Discrimination
 The firm must be able to differentiate
between consumer segments and be
able to put them in groups based upon
income or geography.
 The firm must be able to differentiate
between elasticity of demand for
consumers.
3rd Degree Price Discrimination
when firms recognize that the demand
for their product is different for each
group of consumers.
 Firms know that charge different prices
to different groups for the same
product
The pricing strategy can only exist when
firms have some price setting power.
3rd Degree Price Discrimination
 The firm must be able to differentiate
between consumer segments and be
able to put them in groups based upon
income or geography
The firm must be able to differentiate
between elasticity of demand for
consumers.
3rd Degree Price Discrimination
Treat each segment as a separate
market– then do MR=MC in each
 The firms Segment markets in some
way. Charge all in the segment the
same prices.
3rd Degree Price Discrimination
 Different Price in Different Places
 Same People
Example
Price of a T-Shirt in Merkato and Bole